American Retirement: The coming train wreck...

John Bogle: The “Train Wreck” Awaiting American Retirement

 

I’d like to cover some history, since you’ve covered some history yourself. You’ve seen a lot of things go by. Let’s just start with the mutual fund industry. Why do we have mutual funds in the first place? Who came up with the idea, and why?

The first actual mutual fund, Mass[achusetts] Investors Trust, was started in 1924. What makes the industry go is the common sense behind it: I would say, number one, diversification — very underrated benefit; number two, efficiency; and number three, for those days, relatively low cost; and number four — I always put this last — management, because management cannot add value, but people somehow feel more comfortable with management looking over their investments.

In those days, by the way, the typical mutual fund was very much like an index fund. They were managed, but they tracked the market for years and years. The first mutual funds were essentially index funds that allowed an investor that didn’t have a lot of money to buy into a fund and therefore diversify, because these were baskets of mini-stocks.

Right. And it was fairly efficient, and it was fairly long term, and it’s focused, the original mutual fund. So they weren’t doing all the trading like they’re doing today. They bought, basically, a basket of blue-chip stocks. …

It began also as a business of trusteeship. Many of the original mutual funds had nothing to do with the marketing of their shares. Firms were out there that sold mutual fund shares and made a commission on it, but they did the buying and selling. We didn’t even think about marketing.

You started a fund, middle-of-the-road fund. They all were in those days, in the late ’20s and early ’30s and into the ’40s and really up to the ’50s. And so they were run by trustees who felt a certain sense, I think, of fiduciary duty to their investors. Marketing was not in the middle of the picture. Marketing [was] peripheral, even if the manager controlled the marketer.

And when you had only one fund, think about your perspective. Like I was at the Wellington Fund. When I joined the firm in 1951, [it] was the only fund we had. We lived and died with Wellington Fund. It was a fund that we wanted to take good care of, and we knew what it was doing every minute of every day.

Today all that has vanished. These private investment managers, trustees if you will, have been replaced often by giant financial conglomerates that bought into the fund business, or by fund managers that could see the profitability in it, that went public and had public investors.

Of the 50 largest funds, I think the number is about six that are still privately held, and then there’s Vanguard, which is held by its own shareholders — better than privately held, as it turns out.

Then all of a sudden, instead of one fund that we’re looking after as trustees, we’re in the marketing business. So now the big firms, including Vanguard, have 150, 250, 350 different funds under one management. People can’t possibly know; the directors can’t know; the management can’t know. You can’t track 300 funds or 200 funds. It’s a marketing business.

We need one for this sector of the market, one for growth, one for value, one for emerging markets, one for energy, one for health care. So we respond to the needs of the market and lose our focus on serving the investor rather than serving ourselves, to be truthful, and meeting the needs of the marketplace. It’s a very different business.

Why isn’t that a good idea? You’ve now diversified into many different sectors, and there’s a fund for everybody, and started a marketing machine that goes out and informs people of all the choices they have.

The less choice the better. Choice is your enemy, because you choose based on one thing: past performance. Past performance does not recur. And you also start to get, in the marketing business, very extreme kinds of investment approaches.

For example, in the Internet age, information age if you will, back in the late 1990s, people were starting Internet funds. They went crashing down, and half of them, three-quarters of them, maybe 80 percent of them are now gone.

So it’s not a good idea to try and feed the market. It’s a good idea to watch over what you’ve already got and make sure you do the best possible job, because fads and fashions come and go.

When I joined this business, it was a profession with elements of a business. Today the mutual fund industry is a business with elements of a profession, and too few elements at that.

And by profession you mean a trust that has the interest of the consumer, the client, in mind, as opposed to a business that has its own interests in mind.

Exactly so. Business has an obvious reason for existence — to earn a profit, and that’s a profit for the management company. It doesn’t take a genius to know that the bigger the profit of the management company, the smaller the profit that investors get, because they’re both based on gathering assets and raising fees.

So the more assets you have, the more fees you get. And when you could cut them back to help the fund shareholder, you’re faced with this no-man-can-serve-two-masters dilemma. Should you serve the owners of the management company, now public or owned by a conglomerate, which is to serve the interest of the fund shareholders?

And cost is a crucial issue, how the returns of investing are allocated between investors and money managers or marketers. So the money managers always want more, and that’s natural enough in most businesses, but it’s not right for this business. In a sense then, marketing, competition, all of this, it’s the capitalist system at its core. It’s about competition. It’s about inventing a better light bulb.

But this is not serving, in this case, consumers. It is not serving consumers for the very simple reason, I call it “the relentless rules of humble arithmetic” after Justice [Louis] Brandeis. And that is, we still think 2 and 2 makes 4, or 2 minus 2 equals zero. But when we talk about the market, we’re talking about the market return, and that return is allocated between investors and managers.

So the relentless rules of arithmetic say essentially, this gross return that all of us earn in the markets, minus the cost of thank you, gaining that service –

Fees, expenses, portfolio turnover inside of the fund, sales loads, advisory fees, operating expenses — take them all out, and the net return divided up by investors is what’s left. So costs are a crucial part of the equation.

And a lot of people say, “So what?” Well, think about this. We’re lucky enough to get a 7 percent return on the market. That means it should not surprise anybody that investors as a group divide up 7 percent. Suppose it costs two percent — maybe a little bit high but in the ballpark — to gain that return. Then investors who grossed 7 percent will net 5 percent.

Now, when the market’s going up, as it did in the ’80s and ’90s, at 17 percent a year, 2 percent doesn’t seem like much. But it’s an awful lot. And if you compound a 7 percent and the 5 percent return over, say, 50 years, let’s call that an investment lifetime — well, in fact the investment lifetime is longer than that — something like 70 percent of the market return goes to the purveyors of the services, Wall Street if you will, and 30 percent goes to the fund owners.

So it’s greatly underrated, in part because we’re all so short-term-focused. We don’t think about investing for a lifetime.

Say I have $100, and I’m paying 1 to 2 percent of that in fees. [How is it possible] that at the end of my retirement life I’m only taking home 30 percent of what I would have taken home if I hadn’t been charged those fees?

What it is is the classic example all of us have been taught, probably from grade school on, about the magic of compounding returns, compound interest if you will, over the long term.

What happens in the fund business is the magic of compound returns is overwhelmed by the tyranny of compounding cost. It’s a mathematical fact. There’s no getting around it. The fact that we don’t look at it, too bad for us.

What is a fiduciary, and what happened to the business? The fiduciary is one who is entrusted with the responsibility, in this case the assets of others, and the duty of a fiduciary is to put the interest of those persons for whom he is running the money first before his own.

And that’s a contractual agreement. It’s not quite a contractual agreement, but it is certainly a mutual understanding and absolutely consistent with what the Investment Company Act of 1940 — our guiding statute in the fund business — says, which is the interest of mutual fund shareholders must be placed ahead of the interest of fund trustees, managers, officers and directors and distributors. And that’s not happening.

It wasn’t until the introduction of the IRA [individual retirement account] that you started to see ordinary people buy into mutual funds. What’s the importance of the ERISA act [Employee Retirement Income Security Act] of [1974] and the launching of the IRA?

Well, that’s going to be important later on. But [what] really happened [was] as we got into the middle 1960s, it was called the go-go era. It was the era of the hot mutual fund, the funds that were betting on stock prices rather than the stock intrinsic values.

A plethora of funds were created to meet the demand for go-go funds, and that was the start of changing this industry from what was essentially a conservative industry to essentially an aggressive marketing industry. That’s where it began.

Then that [was] followed [by] … two decades, the ’80s and the ’90s, [in] which stock market returns averaged 17 percent. Stock values didn’t do so much during that period, but stock multiples, stock evaluations, price earnings multiples went from 10 at the beginning of the ’80s, 10 times earnings, $10 to buy a dollar of earnings, to 20 times at the end of the ’80s and to 40 times at the end of the ’90s.

In other words, the value of the share in terms of the company’s overall worth didn’t really change, but what changed was the willingness of people to just pay more for it. Speculative.

Speculation. … And it’s a pretty simple equation. First, when you buy in, you know what the dividend yield is. And second, you know that earnings have a very high correlation with the GDP, gross domestic product, in the United States. Corporate earnings grow very roughly with America.

So you’ve got one, a well-known and given fact, the yield, and two, a reasonable expectation that corporations will grow with the country. And the country should have a normal growth rate, nominal growth rate adjusted for inflation, of around 5 percent.

You have 3 percent inflation that helps to build up the values, and so you get 2 percent real, after adjustment or inflation, earnings growth. So people are paying a lot of money for, when you think about it, 2 percent real earnings growth. That’s all it is. That’s all it will ever be.

If [you have] 2 percent earnings growth over time, then you have about a 2 percent dividend. That’s another big thing that changed. We started off the ’80s, at least in the late ’70s, the dividend yield was almost 6 percent. By the end of the ’80s, it was almost 3 percent, and by the end of the ’90s, it was 1 percent.

Because we had all these dot-com stocks that didn’t pay any dividends. Yeah, and also people were bidding up prices generally.  So what’s this business about? First of all, the long-term return on stocks is 9 percent, OK? That’s the historical return, because it averages 4.5 percent of dividend yield averages over 100 years and 4.5 percent of earnings growth. That’s the 9.

But your prediction for the future is lower than that. It’s lower than that in part to give you the simple part. The original returns I just told you [were] based on a 4.5 percent opening dividend yield, and now we have a 2 percent dividend yield.

So going forward, … it seems like by your scenario, there’s very, very little money to be made. Look at it this way. If the dividend yield is 2 percent lower than the long-term return of 9 percent, we’ll drop to 7. It’s a deadweight loss, that dividend. So 7 percent is a pretty good return in this day and age, because bonds are yielding maybe 2, maybe 3 percent depending on your portfolio. So stocks are really a pretty good investment for the next 10 years. Should be.

But once you subtract your fees, you adjust for inflation, and you subtract tax costs, you’re down into pretty paltry return, 1 or 2 percent. We don’t tell people that, you see, in this business.

I’m not selling managed mutual funds. I created the first index mutual fund. So instead of taking out, say, 2 percent a year from the market’s return, I’m going take five basis points, less than 0.1 of 1 percent out of that market return. So if we get a 7 percent return, I’m going to give you 6.95 in the index fund because it only costs 0.5 of 1 percent to run.

So I take out the management cost, I take out the portfolio turnover cost, I take out almost all the tax cost, because we’re not trading all the time and realizing capital gains. I don’t mean to be commercial about this, but it is simply mathematically a proposition that cannot be disproven.

In terms of the evolution of America’s retirement health, we’ve moved from defined benefit programs, pensions, to defined contribution. … Describe what’s happening to our retirement health as these [different] instruments are introduced and the rush of people into mutual funds.

In my new book, which is called The Clash of the Cultures, I have a chapter on future retirement planning, and it says our retirement system is … headed for a train wreck unless we do something about it.

I start off, simply put, with Social Security, which has to be changed in gradual, small ways to become solvent again. … Then you go to corporate defined benefit plans. They are assuming — and state and local government defined benefit plans even worse — they are all assuming that the market return in their portfolio will be 8 percent a year.

There is no way under the sun that they’re going to earn 8 percent. It’s just impossible. No matter what they do, they’re stuck in a bind given the kind of markets we expect in stocks and bonds. … The best they can really hope for is a 5 percent return unless some wonderful, attractive scenario for the future unfolds, which is really unimaginable. If anything, it’s going to be worse.

So if you think about them compounding their returns at 4 percent instead of the 8 percent that they build into the plan, they’re going to have to start putting a lot of money into those plans. They’re going to be bankrupt.

They’re dropping out. They’re changing to defined contribution plans, the corporations are. But if you have a bad year, you don’t make any contributions for your employees, the management says, “Can’t afford it this year,” well, that’s the year they should afford it. So the defined contribution system is deeply flawed.

And what it really is — when you look at IRA and 401(k), and particularly 401(k) thrift plans — they are thrift plans. They are not retirement plans. They were never designed to be retirement plans, but we’re using them to build a retirement plan now, and it simply is not going to work. …

The 401(k) arrived. What prompted its creation? Some very smart people found a sort of loophole in the law, not a bad loophole, where you could have companies put their money in and employees put their money in together, and you could get clearance to make sure that didn’t have any taxes on it. That’s the 401(k) plan in essence.

But you can get out of it when you want. You can say you have an emergency when you want. And here’s the worst of it: You can pick any fund that you want.

If you want to gamble with your retirement money, all I can say is be my guest, but be aware of the mathematical reality. The chances you will do better playing that game are infinitely small. If I want to put a number on it, let me just say [off the] top of the head that maybe you have 0.1 of 1 percent chance of beating the market over time.

Now, think about this for a minute. You’re 25 years old, and you’re going to invest for the next 50 years, so you’re going to buy an index fund and hold it all that time. You never have to worry about the manager. There aren’t new brooms that come in and sweep clean.

Now you buy an actually managed fund. First of all, half of the actively managed mutual funds that are out there today aren’t going to be around 10 years from now. There’s going to be a 50 percent failure rate. We’ve had that in the past, in the last 20 years. …

So how can you be a long-term investor if the fund you own doesn’t last for the long term? And then there’s something else. Even if you’re lucky enough to be in that half of funds that does survive, they’re going to have a new manager every five years. That’s how long a portfolio manager lasts in this business.

So if you have, say, four mutual funds, you’re going to have four managers every five years, and if you take that to 50 years, you’re going to have 40 managers. Think about the possibility of 40 mutual fund managers with those high fees coming anywhere near the return of an unmanaged low-expense index fund. It just isn’t there. Mathematically can’t be there.

The marketing tells you otherwise. And the industry has created legends, such as Peter Lynch at Fidelity Magellan Fund, who outperform the broad market, outperform your index fund, year after year after year. So in the interest of giving people choices, the industry puts forward funds like Magellan and gives you an opportunity to beat the market. Isn’t that a good thing?

Well, if only the past were prologue it would be a great thing. But look, the Magellan Funds are a great example. … The pressure from employers to bring in outside funds, to have “open architecture” for their investors, was so powerful that we allowed them to add Magellan Fund.

Bad judgment. Magellan Fund reached its peak over the market in 1992. It had $105 billion of assets in 1992. It has been pretty much an abject failure, worse than mediocre, in the 20 years that followed. Way below par. And the fund now has assets of $10 billion. That’s $95 billion smaller, 92 percent smaller than it was in 1992. Everybody’s getting out of Magellan now.

You write pretty scathingly about Wall Street, the rise of speculation, the rise of high-frequency trading, and what this has done to people’s retirement hopes and dreams.

All I offer is the facts. … Now, principal function of the financial system is to oil the machinery of capitalism, so that means raising new money to buy shares in the new companies, the companies that are growing the fastest, the companies that have the greatest potential for profitability, and direct that money there.

We can measure that year after year in initial public offerings, the new companies, and supplementary equity offerings of existing companies. How much do we do of that every year? The answer to that is $250 billion of new money flowing from investors to corporations.

Because this is the collective savings of America that goes into the financial industry, to Wall Street, and then is lent out to companies so they can build new products, build bridges, whatever they do for a living.

Exactly. Perfectly said. Now, what is the reality? … In Wall Street we trade with each other back and forth, obviously to no one’s avail except for Wall Street’s with one another. …

You make bets with each other, so we can’t win as a group. That total is $33 trillion a year. … So if you want to look at it from that vantage point — that’s a little bit oversimplified; I admit that — that means that 99.2 percent of what our financial system does is a casino, and 0.8 percent is classic capitalism, directing new investment to its highest and best and most profitable uses.

I can hear Wall Street saying right now: “Come on, Jack. We’re providing liquidity for the system. All that trading back and forth keeps money moving, keeps things going around, and we all know what happens when that money stops flowing.”It’s not that liquidity is bad. It is good; it is necessary; it is everything.

But how much liquidity do we need? Do we need a market turning over at 250 percent a year? The answer is we never used to. … It’s 10 times as much trading relative to the amount of stock outstanding than there was 60 years ago. We had plenty of liquidity then. We have plenty of liquidity now. And it just makes trading with one another easier and less expensive. I don’t think it’s worth it.

What’s this got to do with me and my retirement funds if Wall Street wants to make a lot of bets? Now, we know that when they make bad bets on a lot of crappy mortgages, that can cause real problems. But generally, when Wall Street’s going about its business and buying and selling with each other, trading derivatives and all sorts of fancy things that are hard to understand, why does that affect my retirement fund?

That’s a really good question, and I can only answer it this way: If you don’t participate in that crazy game, in that busy casino, it affects you zero. …

But most people are part of that system. In other words, your manager is doing that maybe unbeknownst to you. You may be affected by these wild fluctuations we get. You should not be, but a lot of people are. That’s why volumes go way up when we get these flash crashes and things like that.

So get out of the system and you’ll be fine. Ignore the daily fluctuations of the stock market, you’ll be fine. …

So how do I get out? Own an index fund. Own a fund that owns the entire U.S. stock market, does no trading. It has a cost of half of 10 basis points, five basis points, or 0.05 of 1 percent a year to own, and that is the only way to do it. Then you are the creature of the market and not of the casino.

Now you’re telling me I should own the whole market. I don’t get it. Because it doesn’t trade. You don’t get into the trading mentality. You don’t get into the casino math. You own American business, and you hold it forever. That’s what indexing is, as distinct from owning these little segments of American business or big segments and having managers get in and out.

They have a value bias one day and a growth bias the next. They may like technology stocks one day and energy stocks the next and medical care stocks the next, and they get in and out — an unbalance in the market. Nobody gets in and out as a group.

In other words, if you get out of your medical stocks, somebody else is getting into the medical stocks. If you sell, then somebody else is buying. … It is that simple. You talk about you’re the apostle of simplicity. Yeah, Occam’s razor. Where there are multiple solutions to a problem, choose the simplest one. It’s served me well.

A lot of people would say: “Well, that’s boring. I can do better. I know an adviser who is making good returns, and if I go with that guy or that woman, I’ll do better.”

Returns do not persist. The good markets turn to bad markets; bad markets turn to good markets. Funds with hot performance, say Magellan, they peak.

I’ve got a chart of about the eight most popular funds of the modern era. … They peak and then they fall, but you fall in love with them at the peak. Nobody falls in love with them when they’ve done nothing.

So the system is almost rigged against human psychology that says [if] something has done well in the past, it will do well in the future. That is not true. That is categorically false.

The high likelihood — there’s never a certainty in this — a high likelihood is when you get to somebody at its peak, he’s about to go down to the valley. The last shall be first and the first shall be last.

The chief over at Fidelity once said of your index funds that he didn’t think that most Americans would be satisfied with average returns.

He sure said that, and now he’s the second biggest indexer in the business. So I don’t know. My guess is marketing sense got in the way of his certainty about what investors want. …

That first index fund that I started, it was called “Bogle’s folly.” People laughed about it. Why would you be satisfied with an average surgeon? Why would you be satisfied with an average lawyer? That reflects a fundamental misunderstanding of what the markets are.

We are all average. If somebody has a skill that differentiates them for a while, no longer than that, then somebody’s going to be below the market by the exact same amount. And it all comes out in the end. It all evens out in the end. Nothing could be clearer than the record of the mutual fund industry. There’s no persistence in performance over the long run. None, nada, nil. [In] 2006 we got the Pension Protection Act. Did that help us? Not nearly enough. Why not? They had done a lot of tinkering with it.

It seems that all the way through, government has been trying to improve our retirement situation, and all the way through, these changes don’t seem to help us. What happened here?

What there has to be is some kind of I think government agency. And I don’t happen to be a big believer in bringing the government in whenever there’s a problem, but I don’t see how to avoid it here.

And there should be an admission gate to allow you to participate in the defined contribution business. If you’re a very high-cost fund, this agency, or I call it federal retirement board, would say: “Nope, you can’t sell your funds in here. They’re too expensive. They are too imprudent. They’re too short-term in focus,” all those kind of things. “You can’t get in.” It’s saying, essentially, that if you’re not a true fiduciary you cannot get into the system.

The idea behind the Pension Protection Act was, as I understand it, to tighten the rules. But it drove people out of defined benefit programs, and we ended up with more defined contribution.

I’d be skeptical about coming to that conclusion. The reason I’m skeptical is because the companies, corporations that had defined benefit plans could see that they were going to be a constant financial burden, and they didn’t like it.

They transferred the risk over to their employees with a defined thrift plan. … More amateurs were put in charge of their own financial affairs. So you’re responsible for picking your own investments, which generally should be always mutual funds, but you can have a brokerage account in that account. Just insane, because picking individual stocks should be just absolutely out of consideration.

But [companies] said: “So we turn it over to you. We’re going to give you a list of funds from which you can select.” And those lists are generally much larger than they should be, giving innocent employees of a company a whole multiplicity of choices, which is bad. The more you have to choose from in this area, the more complicated it gets, and you don’t know enough to make intelligent choices.

So in your view, we’re not helping people by giving them more choices of where to invest their money? Worst than that, we’re hurting them. It kind of defies logic. I thought it was a good thing to have more choice, more freedom, more ability to play on a bigger field.

In the abstract of course you’re right. When you apply those rules, if you will, to the mutual fund field, it turns out that the average investor is not intelligent enough to make the right choices. And the system in effect causes that investor to make the wrong choices. That is, he ignores cost, he ignores the long term, and he looks for funds that have done better. We don’t market funds that have done very badly. Who would want to buy the worst performing fund over the last decade? We all want to buy the best performing fund over the last decade.

And the odds are probably greater than 50-50 that that worst fund will outperform that best fund in the decade to follow. So it’s counterintuitive, but it’s all in the ebb and flow of investor preferences.

I don’t have a hard time understanding that it’s hard to pick winners, but what I have a hard time understanding is that 2 percent fee that I might pay to an actively managed mutual fund is going to really have a great impact on my future retirement savings. How do you get that across to people?

Well, you have to rely on somebody to get out a compound interest table and look at not the impact on the year’s return, but look on the impact over an investment lifetime.

You compound 7 percent, let’s say as a hypothetical stock market return, and compare it with 5 percent, which is the same stock market return minus 2, and at the end of the investment lifetime, there’s a gap of 30 percent for each 100 cents the market delivers. You get 30 cents, or 30 percent.

I’ve lost two-thirds of my retirement savings. Exactly. It’s mathematically a certainty. … So why don’t we have people asking what I will call, in all modesty, the Bogle question? Do you really want to invest in a system where you put up 100 percent of the capital, you, the mutual fund shareholder, you take 100 percent of the risk, and you get 30 percent of the return?

What percentage of overall money invested in retirement savings is invested in index funds? I’m going to say about 40 percent. So 60 percent of it is invested in funds that charge appreciably more. Yes. So 60 percent of the people somehow aren’t getting the message.

Well, if you saw the curve, with the rise of index funds, including ours and Fidelity’s in particular, and the fall in actively managed fund assets, including particularly Magellan’s and then American Fund’s growth fund, you’d see that … probably 80 percent of the cash flow now is going into the index funds and only 20 percent of the active.

So the trend is positive as far as you see it. The trend is positive. No question about that. What do your competitors over at … all the big mutual fund companies have to say to you? The silence is deafening. They don’t talk to me.

Usually every year I go to the Investment Company Institute general membership meetings down in Washington. And I say a little bit tongue in cheek but not far from the mark that if you’ve been in this business for more than 25 years, you don’t even make eye contact with me. And if you’ve been in the business for five years or less, you say one of two things to me: “Mr. Bogle, you’re my hero,” or, “I wish our firm could run their mutual funds the way your firm does.”

I imagine there’s another thing that they think, some of these executives, and that is that this is a game about making money, and I’m much more successful than Jack Bogle. I’m a billionaire; Jack Bogle’s not. If that’s their objective in life, more power to them. But that’s how success is measured on Wall Street. That’s how success is measured all over America.

Everywhere. Corporate executives get paid a lot of money. Success is making more than your peers. If that’s a remedy for a great society, then I’m just on the wrong track. I don’t think it is.

But you had a simple idea a long time ago that has proven right. It has been proven right year after year after year, because it can’t be proven wrong. It’s a mathematical certainty — a tautology, if you will. What’s happened? Why has greed at this time in our history taken such a firm hold on the American ethos, the business ethos in America?

I think we have a whole lot of false idols out there, number one of which is money. And you know, [there's] nothing the matter with trying to make more money for your family, that kind of thing. That’s the American way, and it’s the right way.

But there is such a thing as a difference between degree and kind, difference of [the] kind when it’s the building of that mountain of money that just gets out of hand. People are going to tell you as they tell me, greed is everywhere; it’s always been with us. I think it’s worse now.

A lot of it is built on a bad financial system. An awful lot of the greed is encapsulated in what Wall Street does, and I think part of that is a change in [the] compensation system. Executives get paid by the price of their stock and not the value of their company.

It’s the easiest thing in the world to make the price of your stock go up for a little while and the most difficult thing in the world to build the intrinsic value of your company over time.

Now, this wouldn’t be so bad except that the money that they’re making money on is retirement money. Other people’s money. And it’s not run the way you would run your own money. I wanted to run the money as if it was their own, and that doesn’t happen. I can’t imagine fund directors owning large amounts of these hot funds that competitors bring out.

There’s just a dark side of the business. They often bring out what we call incubation funds. A firm will go out and start five incubation funds, and they will try and shoot the lights out with all five of them. And of course they don’t with four of them, but they do with one. So they drop the other four and take the one that did very well public with a great record and sell the record.

It’s really disgraceful, and I would say it should be illegal, but I wouldn’t know how to make it quite illegal. You know, it’s a free world. And there have to be higher standards than that for the management of other people’s money.

There’s a lot of different fees that a person with a 401(k) account is charged. Can you name those fees? Somebody said there are as many as 17. I certainly couldn’t name 17, but they’re usually much more bundled than that. And you’ll have a fee for administration and investment management, but part of that will be spent on marketing, and part of it will be spent on the profits to the manager.

And those three fees probably should be individualized and shown separately. On the other hand, the obvious problem that comes along here is the fund has a management fee that does those things all-inclusive. But it also has an administration fee for 401(k)s. Now, a lot goes on behind the scenes. … But as long as you know it comes to a total of 1.5 percent, whatever the number might be, I’m not sure you need to know too much more.

But there should be much more awareness of it, and I always thought that we should disclose to shareholders, retirement shareholders or not, when you send out their annual statement to say how much their fees are in dollar amount — in dollar amount and not ratios. And I got this big argument from the industry — well, it’s very complicated, and people that own funds for a month and are going to look like they have low fees, people that own funds for a year, blah, blah, blah, blah.

But I argued that what you should just do is say, in effect, here’s the fund’s present expense ratio applied to your present investment in the fund. That is to say, multiply the expense ratio times the dollar value of your investment at year end and say here’s the total at basically the annualized cost of the fund.

This is the $3,000 that it’s going to cost you. Easiest thing. Anybody can do that calculation. We all can do it. Every firm in the industry.

The SEC [Securities and Exchange Commission] isn’t willing to compel it. The competitors are going to shun it and probably shun me, too, for my imaginative ideas. But we will be moving toward that.

One thing you need to know is that sensible disclosure will advance as fast as it can. Now it doesn’t advance very rapidly, and we have [to] define that fine line between sensible disclosure and overwhelming disclosure. As the kids would say, there’s such a thing as TMI, too much information.

Right. Too much regulation. Well, it’s not so much too much but maybe regulating the wrong thing too heavily and the right things not enough. One becomes thoroughly disgusted when one looks at this industry and what it’s charging and what it’s giving back, with the value that you’re getting for your investment. I’d do better to keep my money in a mattress, it would seem, given some of these fees that people are paying.

In the egregious cases, the mathematics say you would do better to put your money in a mattress, and sad to say you’d do even better with a money market fund. At least it would earn something. The yield in a typical money market fund today is about 0.1 of 1 percent, so you’re not going to do much better. So you have to go out and try to get a reasonable return on your capital.

But that’s what I was getting at, is that you’re thoroughly disgusted with what Wall Street is doing with your money. At the same time, you don’t have an option but to invest in the market if you want to have a decent retirement.

Index fund. Get Wall Street out of the equation. Get trading out of the equation. Get management fees out of the equation. Get excessive taxes … out of the equation. And then forget it. Have confidence, which is reasonable but not 100 percent sure, that corporate America will grow with America.

To a man from Mars, how would you describe, define the retirement system in the United States? The retirement system is I think by definition a system where investors not only don’t get what they pay for — that is the market return — they get precisely what they don’t pay for. And therefore, the less they pay, the more they get, and if they pay nothing, they get everything.

It’s a system that is designed to fail because simple logic tells us that this massive retirement plan invests trillions of dollars, five, 10 trillions of dollars in pension. In other words, you pick A, I pick B, someone else picks C, D, E and F, and together we own the market. There’s no way around it.

If there’s a big stock in the market, let me call it IBM or Microsoft or even Apple, we’re all going to have more money in Apple than we have in Microsoft and General Motors or whatever and less in the little tiny stocks. That’s the market.

We’re going to look at it that way. We’re going to capture the market return. And we’re going to lose because [of] all the costs that Wall Street charges. …

But I’m a little smarter than the next guy, I think. Absolutely. We all are. And I’m going to talk to Chuck, and he’s going to tell me where I can invest my money. And it’s going to be better advice [because] I’ve been smart enough to figure out where to go to get better advice. And so, yeah, I’m on that side of speculators that are trading often with other speculators, but I’m on the winning side of that group.

You can’t be on the winning side of that group. Why not? Because there are too many time periods, too many different managers, too much diversification among all of the Schwab clients as a whole to be other than an index fund. But it’s an expensive index fund.

Warren Buffett would say that he’s on the smart side of those investors. People have brought that up to me before, as you can imagine. And I say name two. Benjamin Graham, Warren Buffett. Well, Benjamin Graham is no longer around to manage your money. And by the way, he went through some terrible travails himself. He was probably the wisest investor of all time.

He looked at things in a very simple way. He called attention to the very flaws that I’m talking about. He said: “In the short run, the stock market is a voting machine. In the long run, the stock market is a weighing machine.” That’s the difference between speculation, voting, and intrinsic value, weighing.

He was a very wise man. He said, look, what are these institutions doing? They’re taking in each other’s laundry every day, cleaning it up and then sending the laundry out to their fellow institutions. There can be no profit for that except for the laundry.

And a few wise people like Benjamin Graham in his time, Warren Buffett in his time, and a few others. But there were stars in the mutual fund industry — Michael Price of Mutual Series.

Bill Miller, Greg Mason, Peter Lynch. Don’t forget the great Peter, and don’t forget T. Rowe Price Growth. They come and they go, and their records are not sustained, ever. They get up, they peak, and they go down.

So we only hear about the coming and not the going. We only hear about the coming and not the going. And as investors ought to realize, a very central fact, life is just a series of comings and goings, and so is investment performance. Where are we in terms of our retirement health? We’re facing a train wreck.

Put some numbers on that for us. There’s a whole variety of numbers, but the main numbers you can rely on to see this is, a, the failure of the Social Security system. It has to be changed. Second part of it is that corporations and state and local government pension funds are simply assuming returns of 8 percent that are not in the cards, unequivocally not in the cards for the next decade.

So these corporations and state and local government pension plans are going to have to have some help, and it’s not easy to deal with either one of them. The corporations don’t want to be honest about returns because when they are, they’re going to have to put a lot more money into their pension plans, and that’s going to reduce earnings. So Social Security is underfunded. Social Security is underfunded, state and local government underfunded. And the 401(k)?

Its basic problem is that it’s a thrift plan, not a retirement plan. You can take your money out pretty much whenever you want to. You can borrow from it. You can select funds on your own with as much help or non-help as you want. You can talk to your brother-in-law — not usually a good idea. And we know that those choices that are made are bad, unfortunate for investors.

And like the corporations that expect 8 percent but only return 4 to 5 percent, the individual who invests in a 401(k) plan is led to believe, based on past returns of a hot choice on the list of funds that they can invest in, that they can make 9, 10, 11 percent. Is that a problem?

Of course that’s a problem. They can’t do it. Now, this is the problem with the investment business. Somebody will probably do it, and everybody will say: “He got it! He figured it out!” Not so.

If he can do it, I can do it. Exactly, but think about what’s going on here. I think Warren [Buffett] uses this example. You send 100 monkeys into a gym flipping coins, and they keep flipping and flipping, and finally I think it’s one out of 1,200 flips heads every time, and they say he’s a genius. He’s not a genius. There’s always going to be one that flips heads any time period. He’s just a lucky monkey. It’s just the lucky monkey.

You talk about conflicts of interest. What are you talking about there? The most serious conflict of interest that I see today is that money managers are often publicly held by investors who demand a return on their capital. They buy into a publicly held company. It’s called T. Rowe Price.

T. Rowe Price has, odd as it may sound, a fiduciary duty to reward those investors in its common stock. They also have a fiduciary duty to reward fund investors with the highest possible returns. This is a conflict of interest. No man can serve two masters.

There’s another conflict of interest that I wanted to understand, and that is the one that involves revenue sharing. Can you explain why that’s a problem in the 401(k) plans? Let me take a little easier step if I can, take it out of the 401(k) a second to brokers’ distributing firms. They will put you on their list to distribute you funds if you pay them part of the revenue you get from the funds.

Pay to play — that’s exactly what it is. And the thing that’s the matter with that is that the fiduciary entrusted for the management of other people’s money, instead of paying to get in there, would not pay anything and reduce the cost commensurately and therefore increase the returns to the shareholders that he has a duty to.

Now, they’re more in the marketing business to do this. What happened in Vanguard’s case is, I grew up in an industry that we had sales loads like everybody else from 1928 to 1977, when we dropped all those sales loads, maybe a little later than we should, but that was the first time I had an opportunity to do it.

And we went from a supply push — pay off the distributors, sales loads, pay the distributors, leave aside pay (UNINTEL) off, pay off if you need to — to a system of demand pull. Make the product so attractive that it will spread by word of mouth. …

And this is very true of the insurance industry, because whoever offers them the highest commission is apt to get the highest amount of their business. This is crazy.

So if I’m a big insurance company and I’m offering a 401(k) plan out to a bunch of employers, and Fidelity over here wants to get their funds into the mix, they have to pay me to list their funds on my menu of offerings to the customers, the employees?

This is a kind of sub rosa part of this industry, and there’s not a lot of information about it. But the fact of the matter is, as far as I know, that those kind of payments to brokers for distributing your shares has simply become part of the system. Now we don’t have to worry about it here, because we don’t have any brokers. Is there anything wrong with [the fact] that Fidelity pays me to get listed? What’s wrong with it is that that diverts returns from the mutual fund directors to whom you have a fiduciary duty. In other words, if you didn’t do that, you could reduce your fees and have lower expenses for the funds, and when you do that you have higher fees.

So those employees are going to have to pay extra money in fees for when they buy that Fidelity fund so that Fidelity can pay to be listed on the menu. Yeah. Now, I don’t know any specifics about that case, but it’s an example that I think is the way the industry works today.

So we don’t know if that’s Fidelity’s habit, but it certainly is the way the industry as a whole works. It permeates the industry. The brokers are getting a little religion here. They’re saying: “Why should I distribute your funds unless you pay me to? You get these big management fees. I want some of it. You’re getting plenty. Give me some.”

And who pays for that? The fund shareholders. They pay it in the way of foregone expense reductions. The employees. Yep — well, the employees in the 401(k)s.